Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Jiangsu Huachen Transformer Co., Ltd. (SHSE:603097) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Jiangsu Huachen Transformer Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Jiangsu Huachen Transformer had debt of CN¥325.8m, up from CN¥154.9m in one year. However, it also had CN¥142.2m in cash, and so its net debt is CN¥183.5m.

How Strong Is Jiangsu Huachen Transformer's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu Huachen Transformer had liabilities of CN¥726.1m falling due within a year, and liabilities of CN¥33.0m due beyond that. Offsetting this, it had CN¥142.2m in cash and CN¥875.0m in receivables that were due within 12 months. So it can boast CN¥258.1m more liquid assets than total liabilities.

This surplus suggests that Jiangsu Huachen Transformer has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Jiangsu Huachen Transformer has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 50.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Better yet, Jiangsu Huachen Transformer grew its EBIT by 122% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Jiangsu Huachen Transformer's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Jiangsu Huachen Transformer saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

The good news is that Jiangsu Huachen Transformer's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Jiangsu Huachen Transformer is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Jiangsu Huachen Transformer is showing 2 warning signs in our investment analysis , and 1 of those is significant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com